India's Derivative Tax Increase Hits Fund Arbitrage Strategies

India’s hedge fund industry is facing a return crisis after the government announced tax reforms that shocked the market. The decision to increase tax rates on equity derivatives has shaken previously safe investment plans. According to data from Jin10, the $36 billion arbitrage industry now needs to adjust its strategies given the significant impact of these tax hikes on profitability.

Tax Reforms Exceed Initial Targets

Last week’s parliamentary announcement was aimed at curbing high-risk speculative trading in options markets. However, the side effects of the tax increase have instead affected hedge funds, a sector generally considered to have a lower risk profile and a preferred choice for investors during volatile market conditions. The tax structure change has increased operational costs for spot-futures arbitrage strategies, which exploit price differences between the spot and futures markets for measurable gains.

Rather than achieving its goal of limiting speculation, this tax hike has expanded its impact to the more conservative and stable arbitrage segments. Funds that previously relied on narrow profit margins now have to accept a significant portion of their returns being eroded by the additional tax burden.

Spot-Futures Arbitrage: Thin Margin Strategy at Risk of Erosion

The arbitrage spread—the profit margin from this strategy—has never been large. Aditya Agarwal, a co-founder of wealth management platform Wealthy.in, explains that arbitrage spreads typically range only from 0.6% to 0.8% per month. With such a razor-thin margin, any increase in transaction costs will proportionally affect investors’ bottom line.

The arbitrage structure itself depends on cost efficiency. When the government imposes higher taxes on derivatives, profit calculations that were previously well-estimated can turn negative or even lead to losses. There is no room for negotiation in this strategy—when costs rise, returns are directly impacted.

Investors Face Dilemma: Declining Returns, Limited Options

Arbitrage funds that have attracted both institutional and retail investors now face a harsh reality. The tax hike makes the previously viable business model unattractive. Investors expecting stable returns from arbitrage strategies must reconsider their capital allocations.

The pressing question for fund managers is whether to seek alternative jurisdictions or accept even thinner profit margins. In this scenario, India’s arbitrage industry becomes less competitive on the international stage, especially for investors who have the option to relocate strategies to more tax-friendly jurisdictions.

With no signals from the government indicating that these tax increases will be reviewed soon, the industry appears to have to adapt to this new reality or face brain drain to markets that are more profitable for arbitrage strategies.